Advanced Marketing Forum Question

Lump sum Distribution from a Rabbi Trust

Question:
There is a client, age 40, earning around $350,000/year, and will be receiving a distribution from a Rabbi trust NCDC plan in the amount of $600,000. This company has self-funded the plan, and the entire benefit will be a lump sum distribution. Are there any strategies to spread out/shelter the taxation?

Reply #1:
The answer to your question depends on the exact "facts and circumstances" of your client's situation i.e. exactly how close is he to the distribution? What is the wording in the nonqualified agreement? etc.etc.

What you are trying to do is extend the deferral without constructive receipt and income taxation. So the question becomes: If the executive has a right to choose to keep his money subject to a risk of forfeiture, does he, because of this choice, really have constructive receipt the moment he has the right to choose? Changing the payout stream or extending the deferral period can attract IRS scrutiny and involves a degree of risk as Section 83 that addresses this area has no clear answer.

Some advisors believe that the key to downsizing the risk is to have the employer and employee "mutually renegotiate" the agreement to change the payout period or to extend the deferral. You are creating a paper trail to show that this is a bona fide amendment to the plan -- and that it is not being done just to avoid taxation. For example, the employee could agree to provide further services in return for an extension of the deferral period or to receive additional payout over a period of years rather than a lump sum.

There are some court cases on "rolling risk of forfeiture” that can be used as models.

Marie Boric CPA, M,T CFP
Director, Advance Marketing Prudential Financial

Reply #2:
Assuming the client could avoid the constructive receipt and economic benefit doctrines, one possible strategy would be a "swap" of the NQDC plan for a split dollar plan. This could spread the benefit out, and possibly reduce overall taxes, over the life of the plan.

The idea would be that the client would exchange the future lump sum payout (this could be done on a partial basis) for a commitment by the company to fund a split dollar plan. (Under the new split dollar rules, it might be structured as a loan transaction). The life insurance might be purchased inside of an ILIT and could be single life or 2nd-to-die.

Jean E. Dragon, Tax Counsel
Allstate Life Insurance Company
3100 Sanders Road, Suite N5A
Northbrook, IL 60062
Phone: (847) 402-3590 or (800) 470-4377 x6
Fax: (847) 402-4248
E-mail: jdra7@allstate.com

Reply #3:
First, if he's earning $350,000/yr, and age 40, why is he taking the distribution unless he has to? Is he staying with the current employer or is he taking the distribution because he is switching jobs?

Second, since the whole point of this NCDC plan was deferral, maybe he can make an agreement with his employer (either old or new) to start a new deferral of his $350,000 that he would be earning the next 2 years. He is taking distribution income of $600,000 and it seems like he really should defer what he can. So he takes a hit on $600,000, not $950,000. What a great opportunity to defer that $350,000 into a tax-deferred growth funding mechanism....

Roy D. Patterson, JD, CLU
Estate and Business Planning Hartford Life

Reply #4:
One strategy would be for the employee to urge the employer to set up (or convert an existing plan into) a Section 83 executive deferred compensation plan. This is a type of plan that appeals specifically to this type of highly compensated employee and is often used by employers as an attraction and retention tool. The Section 83 plan allows for the employee to defer up to 100% of his/her compensation every year and put it in the plan which uses options as the deferring vehicle. The plan then allows for the "option" to be funded with an "at risk" investment, such as stocks mutual funds or variable annuities. In this way, the employee has a right to purchase this investment at a discount at a future date.

If the employer establishes this plan to benefit the employee, the employee can (within the parameters of the plan design) exercise his/her option at any time. He/she can also leave the company and decide not to cash out of the plan for several years, or may do so (again, as long as allowed by the plan design) in increments. In this way, the employee is not forced to take lump sum distributions and may spread out the taxes.

Lena Rizkallah, JD, AVP
Director of Charitable and Estate Planning Special Markets Department
Manulife Wood Logan, Inc.
Phone: (800) 334-4437 x7628

* The foregoing is for broker/agent use only, and is intended solely for informational purposes. Nothing contained herein should be construed as legal or tax advice, and should not be relied upon for such. Legal and tax advice should only be obtained from your attorney or qualified tax professional.

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